Rebalance Periodically, Review Frequently

The risk premium for a broadly diversified, unmanaged portfolio of asset classes is expected to fall in the years ahead. Can this trend be offset by working smarter and making better rebalancing decisions? In theory, yes. In practice, only a minority of investors can avail themselves of benchmark-beating results in the long run. True for individual asset classes, true for asset allocation. That's the nature of the arithmetic of active management. But if there's any chance for success on this front, most of the strategic intelligence for improving results will come from within your portfolio, as I discussed a few weeks ago. Carefully monitoring the fluctuations in your asset allocation doesn't insure that you'll earn a higher risk premium, but it's a lot harder (impossible?) to enhance results if you don't fully exploit this information for managing the portfolio.

Where to start? For my own portfolio and some consulting work, I regularly analyze portfolios of ETFs and mutual funds through a proprietary model that runs in R, the statistical software environment. Daily observations aren't necessary, but a weekly review is recommended. Rebalancing is far less frequent, of course, but it's important to develop a comfort level with how your portfolio is evolving. Indeed, there are times when rebalancing opportunities arise that are unusually attractive but fleeting—opportunities that you may overlook if you're reviewing asset allocation on a monthly or quarterly frequency.

As a brief review of how I slice and dice portfolio data, let's take a basic example—the Global Market Index (GMI), my in-house benchmark that's comprised of the major asset classes. For simplicity, let's assume that you invested in an equally weighted version of GMI at the close of 2012 using 14 ETFs to represent the various components. Let's also assume that the portfolio was left unrebalanced through March 13. Here's how the internal portfolio structure stacks up as of that date, based on running the numbers through my analytics program:

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The chart above summarizes three key pieces of information across the portfolio, starting with a comparison of the current allocations, indicated by the gray bars. Next, we can review how the current allocations have shifted relative to the target allocation, which in this case is simply the equal weights for all 14 asset classes (or roughly 7.14% for each fund), as shown by the horizontal green line. The chart also shows the historical allocation extremes for the period under review, as shown by the blue and red squares for each asset class.

Unsurprisingly, the allocations haven't changed all that much on a year-to-date basis. But in relative terms, a few trends are worth watching as potential rebalancing opportunities down the road. For instance, the US equity allocation has made the biggest upside move so far--as of March 13 it was at its highest allocation for the year to date. This bullish move has been financed, so to speak, by falling allocations elsewhere in the portfolio. Looking at the opposite end of the spectrum, by losses elsewhere in the portfolio. For instance, government bonds in developed markets have retreated the most, residing at the lowest allocation of the year so far.

Astute readers will note that the allocation shifts above equate with the year-to-date returns, which may inspire some to ask: What's the point of running this type of analysis? The answer, of course, is that portfolios in the real world don't have tidy start dates and equally weighted initial allocations. In other words, looking at total returns for individual asset classes isn't usually all that helpful for dissecting the nuances of your portfolio. An integrated approach that reviews your strategy in context is critical. Asset allocation data is often messy and so it's essential to have a process that can cut through the noise and deliver useful perspective on a regular basis. This is particularly essential for advisors who are overseeing multiple portfolios that cover a broad array of structures.

The first cut of portfolio analysis should start with the most important information at your disposal for making informed rebalancing decisions. The good news is that this information is easily obtained on a real-time basis. Yes, there are other inputs to consider for managing asset allocation. But it all pales compared with the evolving structure of your portfolio.

The challenge, then, is one of routinely monitoring this structure and develop a deeper level of familiarity with how the fluctuations in the asset allocation relate with risk and return and the business cycle. It's a bit like a general commanding troops in battle. Decisions on when to attack, retreat, or hold your position are relatively infrequent, but continual vigilance is still essential in order to win the war.